Mutual Funds for Beginners

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  • 03 Feb 2023

Mutual funds offer some notable advantages over other investment tools. For starters, they provide liquidity and good returns. They also serve as good starting points for people who are new to stock market investing. Of course, beginners are sure to have lots of questions: What are mutual funds? What are the types of mutual funds? How should one invest in them? Here’s a guide to get you primed on the basics of mutual fund investment.

Mutual funds are investment avenues where funds are collected from different investors. Instead of directly investing in an asset, investors transfer money to a mutual fund scheme that then invests in a range of assets. This is quite useful for individual investors who wish to invest in stocks but lack knowledge about the markets. Individuals may also lack the time and resources to carry out thorough research and analysis before investing. Mutual funds help plug this gap by taking asset allocation decisions on behalf of their investors.

Let’s examine what happens once you invest in a mutual fund:

  • The fund house will allot you a certain number of units depending on the current net asset value (NAV) of the fund. The NAV is the value of total assets less liabilities of the fund. Mutual funds declare a fresh NAV daily.
  • The mutual fund scheme will charge a specified sum for processing the investment.
  • The balance amount will be used to purchase units in the fund.

Example: Say, you invest Rs 50,000 in a mutual fund. The fund charges Rs 150 as its processing fee and the current NAV of the fund is Rs 15. Your total investment, therefore, is Rs 49,850. And at the NAV of Rs 15, you will get 3323.33 mutual fund units. (Yes, it is possible to get part units as well!)

Once you invest in a mutual fund, you become a part-owner of the assets that the mutual fund holds. Your ownership is proportionate to the number of units you hold. What’s more? You can withdraw your funds from the mutual fund at any time.

Besides, the burden of asset allocation does not fall on you. Mutual funds are managed by professional fund managers. These fund managers, supported by their research teams, adjust and tweak the fund’s investment strategy based on market conditions.

Mutual funds can be classified into different types based on different criteria:

1. Period in which investments can be made

  • Open-ended mutual funds: Investors can buy and sell units in these funds at any time at the current NAV. It is possible to purchase units in open-ended mutual funds even after the initial offer period—also known as the new fund offer (NFO) period. The number of outstanding units varies based on the number of units sold or repurchased by the fund. Since investors can subscribe to the scheme and redeem units at any time, these funds are a fairly liquid investment option.

  • Close-ended mutual funds: New subscriptions to these funds are possible only during the NFO period. Once this period is over, the investor’s funds are locked in till the fund matures. However, the units can be traded on the secondary market by the investors. And sometimes, the funds may offer to repurchase the units. Unlike with open-ended funds, the number of outstanding units does not change.

2. Investment strategy

  • Active mutual funds: An active mutual fund has an investment strategy that changes based on market conditions. The fund manager and his team constantly rework the strategy and the holdings to ensure the fund generates returns for the investors. The advantage of active mutual funds is that their asset allocation can be modified to bring the maximum returns based on current market conditions.

  • Passive mutual funds: This includes exchange-traded funds (ETF), index funds, and commodity funds. Passive mutual funds only track the movement of an underlying asset. ETFs, for example, track the movement of either an index or a commodity. They are traded on stock exchanges just like equity shares. Index funds track a particular index like Sensex or Nifty 50. Since passive mutual funds simply follow an underlying asset, they don’t need to adapt their investment strategy constantly. As a result, the cost to the investor is lower.

3. Asset classes

  • Equity mutual funds:

These funds invest 65% or more of their resources in listed equity shares of companies. A small percentage of the funds are placed in fixed-income assets to provide steady returns. Among equity mutual funds, there are different categories of funds:

- Based on market capitalisation: Heard of large-cap, mid-cap, and small-cap mutual funds? These funds invest in the shares of companies based on their market capitalisation (or market cap). Large-cap companies are generally big and stable businesses whose shares bring steady returns. Mid-caps are mid-sized companies. They have a greater potential for growth than do large-caps but are also somewhat riskier investment prospects. Small-cap companies are smaller still and carry even more risk. But they have a huge potential for growth, and small-cap funds that do well could bring high returns.

- Based on investment strategy: - Sectoral funds: These funds invest in a particular sector—for example, banking and financial services, IT and ITES, pharma, and so on. The returns from these funds are linked to the performance of the sector. - Thematic funds: Thematic funds pick a certain theme when making investments. Their approach is slightly broader than in case of sectoral funds. For example, a fund with infrastructure as its theme may invest in companies across sectors like cement, steel, and power. - Value funds: Value funds invest in stocks that are currently undervalued in the market. The stocks are identified through research into the fundamentals of the companies. Why do they take this approach? Since they consider the stocks to be undervalued, they expect a price correction is likely. And their strategy is to profit from such a price rise in future. - Contra funds: Contra funds follow a contrarian investment strategy. They invest opposite to the direction in which the market is going. If the market is rising and some shares are falling, contra funds will pick the falling shares. The goal here is to pinpoint mispriced assets that may appreciate in future. But unlike value funds, contra funds do not look at company fundamentals. Instead they focus on shares that decline following a temporary setback but are likely to pick up again. - Focused fund: Focused funds invest in equity shares. But they cap the total number of shares held in their portfolio to 30.

- Based on tax savings: Equity-linked savings scheme (ELSS) is a tax-saving mutual fund. Investors get a tax deduction under Section 80C of up to Rs 1.5 lakh. But there is a lock-in period of three years. This means the funds cannot be withdrawn until the lock-in period is over.

  • Debt mutual funds:

Debt mutual funds invest in fixed-income instruments which provide stable returns. There are different categories of debt mutual funds based on the maturity period of the instruments they hold. In general, the risk of investing in debt funds is considered to increase as the maturity period increases. For example, investing in a corporate bond fund exposes the mutual fund to a long-term default risk. But this risk is very low in case of gilt funds which invest in government securities or overnight funds which invest in instruments that mature the next day. Here are some common types of debt funds:

  • Short-term debt funds: - Overnight fund - Liquid fund - Ultra-short-duration fund - Short-duration fund - Low-duration fund - Money market fund

  • Long-term debt funds: - Dynamic bond fund - Floater fund - Credit risk fund - Fixed maturity plans (close-ended funds) - Corporate bond fund - Gilt fund - Medium-duration fund - Medium-to-long-duration fund - Long-duration fund

  • Hybrid mutual funds:

Hybrid mutual funds invest in a mix of equity and debt instruments. Here are some common classifications: - Conservative hybrid funds: These funds invest 65% or more in fixed-income debt instruments and the balance in equity shares. - Aggressive hybrid funds: These funds invest 65% or more in equity shares and the balance in fixed-income instruments. - Arbitrage funds: Arbitrage funds invest in the cash market and the futures market at the same time to cover their risks.

There are different ways to invest in mutual funds. Here are some of the modes that you could use:

1. Invest directly through the mutual fund’s website: You could invest in direct mutual fund plans by visiting the fund house’s website. Direct plans do not pay any commission to agents or brokers. This reduces your costs and boosts your returns. The investment process is simple enough. Create an account on the mutual fund’s website and make the investment through net banking, credit or debit card, or UPI, among other options. Do you have an existing folio with the mutual fund? In that case, simply log in to your account to make fresh investments or switch schemes.

2. Invest through your broker: You can invest in mutual funds through a broker provided you hold a demat account with them. When you invest through your demat account, the mutual fund units will be stored in demat form. You can also redeem the units through your demat account and view your entire mutual fund portfolio in a single place. The broker serves as an intermediary and provides a catalogue of mutual fund schemes on their system. Some brokers also provide direct mutual fund options to their clients.

3. Invest through an agent: Agents like banks and licensed financial intermediaries also help you to invest in mutual funds through their group companies who function as brokers.

There are two modes in which you can invest in mutual funds:

  1. Make a lumpsum investment in a mutual fund scheme of your choice. This is a good way to use up a large bonus, for example.

  2. Invest in a systematic investment plan (SIP). Here, you invest a fixed sum in your chosen scheme at pre-decided intervals, usually monthly or quarterly. Beginners can use the SIP mode to develop the habit of making disciplined investments.

At this stage, you should also think about the mode of pay-out:

  • Dividend plan: Here, you can choose to receive regular dividend payments from your mutual fund investment.
  • Growth plan: In this option, any profits are reinvested in the scheme, allowing you to purchase more mutual fund units. Just keep in mind that dividend income from mutual funds is taxable as per your income tax slab.

Mutual funds in India are regulated by SEBI. They have to comply with SEBI’s regulations concerning asset holdings, disclosure norms, and safeguards for the investor against fraud and embezzlement.

In addition, most mutual funds in the country are members of an industry body called the Association of Mutual Funds in India (AMFI). This association provides ethical and professional standards for mutual funds in the country.

It is also important to understand that a mutual fund house or asset management company (AMC) is the umbrella company which operates different mutual funds. So, an AMC can operate a liquid fund, an equity fund, and a hybrid fund all at the same time.

Before you invest in a mutual fund, it is essential to compare the different available schemes. For this, you will need to focus on a few key aspects:

1. Total expense ratio (TER): This represents the total cost to the investor. TER is calculated as the ratio of total expenses to the total assets of the mutual fund. The higher the TER, the lower your returns. 2. Sharpe ratio: This highlights the returns per unit of risk taken by the mutual fund scheme. A higher value suggests that the returns potential makes the investment worth the risk. 3. Historical performance: Take a look at how the fund has fared across different market phases. Consistent returns over the long-term is generally a good sign. 4. Performance against peers: By comparing similar schemes, you should gauge whether the fund is performing in line with its peers, or if it is doing better or worse than them.

Summing Up

It is also important to have a clear idea of your own investment goals and appetite for risk. This will help you to choose a mutual fund scheme that fits your investment strategy. And if you already have a mutual fund portfolio, evaluate the funds in your kitty once every quarter. This will keep you updated on their performance, and you can exit a fund if the returns are not in line with your expectations.

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